How Business Owners can avoid Personal Liability if others attempt to Pierce the Corporate Veil

Generally, owners of corporations and limited liability companies are not personally liable for business liabilities. However, under some situations, courts allow creditors to “pierce the corporate veil,” to access a corporation or LLC owner’s personal assets. It is vital for business owners to know how, when, and why their personal assets may be vulnerable to their business liabilities. The major considerations the court looks to are whether the company is undercapitalized and if the owner is using the company as an alter ego.

Undercapitalization & Alter Ego

Arizona requires corporations to be adequately capitalized at the time of formation and through the life of the corporation. No exact amount is required, but the purpose is to protect creditors and others with whom the company has liabilities. “Alter Ego” refers to when the owner treats the company as a sole proprietorship, a partnership, or a personal asset rather than as a separate business entity. Accordingly, it is important to take the following steps to avoid piercing of the corporate veil:

* Maintain adequate business capitalization from the inception of the company forward.* Engage in the necessary formalities required for the business entity.* Avoid commingling business and personal assets and activity.* Make the corporation or LLC status known to your clients.* Document all business actions.

1. Ensure adequate capitalization from the inception of the company forward.

All corporations, at the time of formation and throughout the life of the corporation, must be properly capitalized to respond to claims and liabilities arising out of the corporation. No exact amount is required. However, the general test of capitalization is at inception. Therefore, the most important time to have your company capitalized is at its inception. Business owners should then continue to keep the company adequately capitalized throughout the company life relative to current and foreseeable liabilities. Doing so will protect others from piercing the corporate veil to access owners’ personal assets.

2. Engage in necessary formalities.

Corporations have formalities that they must follow. Although LLC law is not as stringent, it is also smart for owners of an LLC to follow such formalities. The court views a company that lacks the necessary formalities as a possible indication the owner is using the company as an alter ego. If the court believes that the owner may be using the company as a sole proprietorship, partnership, then the court may treat the company like a sole proprietorship or a partnership, by allowing the corporate veil to be pierced making the owners personally liable. Owners should ensure their company takes part in the following formalities to avoid personal liability:

Corporations:

* Create, maintain, and update bylaws.* Issue shares of stock to stock owners.* Maintain a stock transfer ledger.* Hold initial and annual meetings with directors and shareholders.* Keep annual filings, fees, and taxes current with the state of incorporation.

LLCs:

* Issue membership certificates to owners.* Keep a membership transfer ledger.* Hold initial and annual meetings of the members and managers.* Keep annual filings, fees, and taxes current with the state of incorporation.

3. Avoid commingling business and personal assets and activity.

Owners should set up a business savings account, business checking account, and business credit cards. They should pay for business expenses with business accounts and personal expenses with personal accounts. Owners should keep their personal assets in their name and the business assets in the name of the business. This will protect business owners against any allegations that they are using the business as an alter ego.

4. Make the corporation or LLC status known to your clients.

Business owners should make the status of the corporation or LLC known to their clients. Business cards and other labels should name the company as a corporation or an LLC. All contracts and documents should be assigned to the business and not the individual owner. Invoices should have the company’s name rather than the owner’s. This will protect against alter ego allegations claiming creditors and clients were unaware the company was a corporation or LLC.

5. Document all business actions.

Business owners should document everything. They should document when they engage in formalities, any evidence that shows they maintained separate accounts for personal and business activities, and any documents showing they maintain adequate business capital. These documents will be the evidence needed to protect the business owner’s personal assets if a creditor attempts to pierce the corporate veil.Business owners should treat their company as a separate entity, should engage in all the necessary formalities required under corporation law, and should document everything. It is always best to seek out attorneys at the inception of the company and throughout as needed. The Arizona business attorneys at Gunderson, Denton, and Peterson PC assist clients with these and many other business legal needs.

Sunday, July 8, 2012

One of the most common questions I get asked by my clients is whether the new business should be formed as an LLC or an S corp. I address this question below.

If I were to summarize this blog in one sentence, then it would be this: the choice of entity is not just a legal question, also involves an analysis of accounting and tax considerations that vary according to the founders’ particular situation. So, in addition to a consultation with an attorney, it is important to schedule a consultation with your accountant. Skipping this step may result in unintended tax consequences and also in legal fees if the owners need to restructure their business entity later on.

Below is a quick summary of legal considerations pertaining to S corporations and LLCs in New York.

S corporation

Corporate structure:

Separate Legal Entity: An S corporation is a separate entity with a legal personality, which means that it can sue and be sued, and it can own property.

Corporate Formalities: It is important for an S corporation to maintain corporate formalities: open separate bank accounts, conduct period meetings of the board of directors, document decisions in a minute book, etc.

Management: An S corporation has centralized management, vested in a board of directors elected by the shareholders. The board oversees the strategic decisions of the corporation and appoints officers who deal with the daily operations of the company. Directors, officers and majority shareholders own fiduciary duties to the shareholders of the corporation.

Limited Liability: Shareholders, directors and officers typically have limited liability for debts and obligations of the corporation, as long as the “corporate veil” is not pierced (this can happen if, for example, corporate formalities are not preserved or there is commingling of funds or fraud).

Shareholders Agreement: It is advisable, but not required, that shareholders enter into a shareholders agreement that outlines internal governance rules of the corporation, such as when shareholders can be admitted to the corporation or resign from it).

Buy-Sell: It is also recommended that shareholders enter into buy-sell agreements.

Special considerations:

An S corporation is a regular business corporation that has elected special tax treatment on the federal and state level (New York City does not recognize “S” corporation status).

Only US citizens or residents can be shareholders of an S corporation.

An S corporation can have only up to 100 shareholders, and all shareholders must be individuals (another corporation or an LLC cannot be shareholders of an S corporation).

All shares must have the same economic rights to profits, distributions and liquidation of assets. This means that even though an S corporation can have voting and non-voting shares, it is not possible for an S corporation to issue preferred stock, since it would have different rights to distributions and a different liquidation preference than common stock.

Tax Considerations:

An S corporation has “pass-through” tax treatment at the federal and state level.

Shareholders of an S corporation who work for the business are considered to be employees and have to pay themselves a reasonable salary (it may result in tax savings as compared to self-employment tax for LLCs but has increased maintenance costs related to payroll).

Limited Liability Companies

Corporate Structure:

Separate Legal Entity: Just like an S corporation, an LLC is a separate legal entity; it can sue and be sued and it can own property.

Corporate Formalities: Unlike an S corporation, an LLC has to maintain only minimum corporate formalities, although it should still have a separate bank account to avoid commingling of business and personal funds of the owners.

Management: In terms of management, LLC is very flexible: it can be member- or manager-managed; it can be run like a corporation, a general partnership or a limited partnership. If the owners so desire, it can have a board of directors, and can refer to its membership interests as “shares”.

Limited Liability: There is limited liability protection for the members and managers of an LLC, absent commingling of funds, fraud or, in cases of single-member LLCs, if the LLC is just an alter-ego of its owner.

Members: LLC can have from one to unlimited number of members, including non-US citizens or entities

Operating Agreement: In New York, all LLCs must enter into an operating agreement within 90 days of formation.

Special Allocations: LLCs allow special allocations of profits and losses among members: members can agree to share profits and losses in proportions different from their membership interests. For example, members can agree that 100% of the profits of an LLC be distributed to one member for the first three years, despite the fact that that member owns only 50% of the LLC and normally should have received only 50% of the profits and losses.

Special Considerations:

Publication Requirement: Within 120 days of formation, all LLCs organized in the State of New York must publish a notice of formation in two newspapers selected by county clerk of the county where the LLC was formed. This can be expensive: publication costs in New York county (Manhattan) are around $1,300.

Consequences of not publishing on time:

LLC will lose authority to do business in NY

It cannot sue anyone in New York courts, but can defend itself

Members may lose limited liability protection.

There is no penalty or fine for complying with this requirement late.

Contracts of an LLC that has not complied with the publication requirement are still enforceable.

Tax Consequences:

LLC enjoys a “check-the-box” taxation: it can elect to be taxed as a disregarded entity, a partnership or a corporation.

If no election is made, a one-member LLC will be treated as a disregarded entity at the federal level; and a multi-member LLC will be treated as a partnership. In such cases, the LLC itself does not pay taxes, but files an informational return.

Members who are actively involved in the business of the LLC pay a 15.3% self-employment tax on 92.35% of net earnings up to $106,800 and everything above is taxed at 2.9%.

LLCs are subject to New York City’s 4% UBT.

Business founders should work together with the attorneys and accountants to determine the best legal entity structure for their business. This will depend on a number of factors, including, but not limited to: the immigration status of the founders, plans to seek outside capital from professional investors, start-up costs, tax consequences, and the desirability of special allocations of profits and losses.

This article is not a legal advice, and was written for general informational purposes only. If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga. Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of business, corporate, securities, and intellectual property law.

About the Author

Arina Shulga is the founder of Shulga Law Firm, P.C. Arina Shulga is a corporate and securities attorney with significant experience in startup law, securities offerings and SEC reporting obligations, cross-border transactions, corporate governance, private and public company representation, periodic reporting filings for public companies, business entity formation, licensing, contracts and employment-related agreements. She is experienced with advising small to mid-sized companies on formation, contract review and negotiation, private placement of securities, intellectual property matters and internal governance issues. Check out her LinkedIn profile.

You can contact Arina at (646) 481-8001, by emailing her at arina@shulgalaw.com or by visiting Shulga Law Firm's website.